Opinion

The Parrot and Commodity Prices

“Teach a parrot the terms ‘supply and demand’ and you’ve got an economist.” That parrot can explain to us what is happening with commodity prices (Chart 1, left side). That is, while agricultural and industrial metal prices - particularly copper - plummeted on average by over 10% since June, energy prices - especially oil - have risen nearly 20% since the beginning of the year. Brent's barrel price is now triple what it was in early 2016. Check the latest World Bank Commodities Price Data (The Pink Sheet) here.

On the demand side, factors common across commodities can be highlighted. The IMF’s World Economic Outlook (WEO) for October showed a slight downgrade in its global GDP forecast compared to the April issue, from 3.9% to 3.7% in 2019-20. As output gaps close and monetary policy is normalized in most advanced economies, their growth tends to move to potential rates well below the average rates typical of the period prior to the global financial crisis of ten years ago (Chart 1, right side). While emerging Asia is expected to maintain strong medium-term prospects, the latest WEO growth forecast for emerging markets and developing countries has been reduced for 2018 and 2019 by 0.2 percentage point and 0.4 percentage point, respectively, as compared to April. The impacts of trade measures implemented since the April 2018 WEO on China and other economies in emerging Asia, the effects on Iran of the re-installment of US sanctions, the economic slowdown in Turkey following the emerging market turmoil since May, and a more subdued outlook for large economies in Latin America (Argentina, Brazil, Mexico) are singled out as main sources of such downward revision.

There is indeed concern on the degree of ongoing deceleration in China's economic growth until investment and retail sales find new paths. Likewise, it is difficult to estimate to what extent possible further rounds of the US-China trade war may adversely affect global growth and specific commodities. According to Citi Research (“4Q 2018 Commodities Market Outlook: the either/or market…or perhaps both!”, September 23, 2018), cross-commodity correlations went up substantially in the third quarter of the year, reflecting the US-China trade spats and corresponding concerns about growth.

These factors have led to waves of enthusiasm and fear which have differently affected various types of commodities, following the succession of favorable or unfavorable news on Chinese growth and trade wars. According to some watchers, the uncertainty and volatility of mood has led investors to shift their positioning from "short" to "long" and vice versa with intensity and frequency above normal.

To explain the divergent behavior of energy prices - oil - up, the parrot has us looking at the supply side. Potential restrictive factors are proving to be more effective and more influential than the prospect of decelerating demand. In addition to continuing production shrinkage in Venezuela and US sanctions on Iran entering into force in November, there are high risks of disappointing production levels in Nigeria, Libya and Iraq (Chart 2, left side).

As oil inventories are short - Chart 2, right side - the possibility of additional negative supply shocks shifting the Brent barrel price well above US$ 80 could only be avoided through a rapidly offsetting response from increased supply by Saudi Arabia and Russia or the US and Canada. Given the low investments on oil extraction in the period between the sudden drop in prices in mid-2014 and the end of 2016, when OPEC members and non-members signed a new agreement to reduce their joint production, some period of higher prices is likely to occur first before such response to new negative shocks takes into effect (as suggested by Arezki et al, 2017). In the short run, swift increases of production in the US would face bottlenecks from labor shortages and insufficient pipeline infrastructure.

Oil prices and their divergent upward movement will impact emerging markets in different ways, depending on their oil-dependence in exports and imports (Canuto, 2015). Take for example the case of Brazil which is still a net importer of oil and oil products. Combined with the real exchange rate devaluation of recent months, such international price increase made for a strongly negative supply shock. If the upward shift in prices persists, the maturation of investments in Brazil pre-salt extraction in the years ahead and the consequent change from importer to a net-exporter status should change the terms of this relationship between the country and oil.

Besides energy-specific developments, it is reasonable to expect an overall decline in cross-commodity correlations, as the diversity of conditions underlying supply and demand in commodity markets may prevail over common factors. Metal prices have suffered downward pressures arising from the trade war, but also because of China’s stronger environmental regulation and tighter credit conditions.

Take the case of iron ore. The intensity of slowing investment and growth in China will strongly affect its market. While there has been a slower pace in the global expansion of its supply capacity in recent times, available inventories remain high and the reuse of scrap has been greatly expanded. Analysts are projecting a demand growth drop even sharper than that on the supply side. A trend for lower prices, the parrot would say.

Agriculture prices have also felt the negative impact of trade frictions and concerns about global growth but again it all depends on case-specific features. In the case of soybeans, e.g. the unfolding of the US-China trade war may bring several possible implications. A good bet is that there will be expansion of production and exports in Brazil and Argentina, due to a change in sources for Chinese demand, with the result in terms of prices depending on what happens between US production and its non-US customers. Nonetheless, soybean prices fell by more than 14% from February and August this year, after China’s retaliatory tariffs on US soybeans. On the other hand, weather-related conditions during spring and summer in Russia and western Europe led to a substantial price spike of wheat (above 22%) in the same period.

Given the weight of global and commodity-specific factors on commodity prices, as well as differences in countries’ commodity-dependence, better keep your parrot close by.

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This article is an update of notes prepared for the “Forecast on Latin America and the Caribbean” conference on Thursday, September 20, Washington, D.C., at the U.S. Chamber’s Association of American Chambers of Commerce in Latin America & the Caribbean (AACCLA).

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